Why dead cats bounce

The buoyant, almost ebullient, mood in stock markets over the past ten weeks sits quite oddly and uneasily against the gloom enveloping the real economy here and offshore.

The macro outlook sketched out in the Reserve Bank’s minutes (Fragile signs of growth), even if viewed optimistically, would see the beginnings of a weak recovery late this year but no really meaningful pick-up in activity until 2011, if everything goes right.

The situation offshore is worse. The IMF and OECD are in agreement that the global economy will continue to shrink this year, with negligible growth in 2010. For the US, the OECD forecast is for zero growth in 2010.

Yet, our sharemarket, while it has fallen back a little from its highs this year, is about 22 per cent above its low-point in March. More puzzling is the 35 per cent rebound in the S&P 500 over the same period. The FTSE is up about 28 per cent.

In the US, first quarter earnings were down about 35 per cent from their levels a year earlier and are expected to continue to fall for at least the next six months. Perhaps they weren’t quite as bad as was feared going into the reporting period but neither corporate performance nor the outlook provides justification for a stock market rally as rapid and as substantial as has been occurring.

Bloomberg has estimated that the S&P 500 is trading at about 14.4 times earnings, compared with a peak of almost 18 times a year ago, but there are a range of valuations of forward earnings that suggest the market is either fairly fully valued relative to historical levels or massively over-valued, depending on how pessimistic the analysts are about the outlook. One investment bank has the market priced at more than 24 times 2010 earnings.

There are three broad reasons why the market seems to be rebounding.

One is that the world hasn’t ended – the global financial system, having nearly imploded when Lehman’s collapsed, has not only survived but is showing tentative signs of life. Credit markets are slowly re-opening and risk premia are subsiding after spiking dramatically as the sub-prime crisis evolved into a fully-fledged financial crisis.

Another is that, in the absence of fresh shocks, the markets believe they can see the bottom of the downturn in the real global economy. It might lie somewhere ahead – whether later this year or sometime next year – but there is confidence that the rate of decline has slowed as the massive and concerted injections of liquidity and stimulus have started to have an impact.

The third is that real interest rates around the world are at historically low levels, making equities relatively, or at least apparently, more attractive.

However, one would have to be doubtful about the profile of any global recovery. It is more likely to be a very subdued and very protracted process than the kind of bounce one might normally expect coming out of recession. This is, after all, the worst crisis since the Great Depression – you wouldn’t expect markets to return to business-as-usual until a clearer picture of life after the crisis emerged.

All the excess liquidity that has been pumped into the global system has to be withdrawn and all the public sector debt committed to the fiscal stimulus packages has to be raised and serviced.

If central banks misjudge the rate at which they wind back the liquidity in the system there could be significant shocks, or a significant outbreak of inflation. It will also take years, perhaps many years, before the globe’s bigger banks have recovered from their self-inflicted wounds.

With developed country debt-to-GDP ratios climbing (with some notable exceptions, including Australia) well above 50 per cent and rising rapidly – the US ratio is expected to almost reach 100 per cent next year – there will be massive demands on debt markets over the next several years at least and inevitably a steep increase in interest rates globally that will put a dampener on whatever level of growth there is.

The enthusiasm for equities appears premature, or at least somewhat overdone on terms of the rate and extent of the rebound.

It may be safer to get back into the market and it is helpful, in a self-reinforcing way, for companies and the market that the recent rebound is helping companies conduct a rapid large-scale recapitalisation of the corporate sector.

However, conditions remain fragile and vulnerable to any new shock and the longer term outlook is quite bleak, given the mountain of legacy issues that will have to be resolved once the crisis and recession have finally passed.
STEPHEN BARTHOLOMEUSZ